The Income Approach to Fair Value

There are very few things which we know which are not capable of being reduced to a mathematical reasoning, and when they cannot, it's a sign that our knowledge of them is very small and confused.

—John Arbuthnot (1667–1735), British mathematician

IN THIS CHAPTER, we come to the third and, in many ways, most important set of valuation methods, the income approach to fair value. Sometimes described as “the very basics of value,” these methods are the most common. Almost every day there is a reference to a price to earnings ratio (PER) in most newspapers' business sections, and the basic discounted cash flow (DCF) value is constantly used by investment bankers.

There are two sets of methods under the income approach. The first, which goes back to the seventeenth century, is the capitalization of the current or projected benefits. Originally it was dividends or other distributions; now it is either the current or next year's forecast net income or cash flow (usually expressed as earnings per share—EPS) by a PER, which reflects the level of interest rates, the risks involved, and the anticipated growth. As most readers are familiar with capitalization methods, we will not spend much time on them.

The more complex DCF method is described by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) as a present value technique. In this, the current value of an asset is the total of all the present values ...

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